LexisNexis

What’s stopping the clean energy transition

Dr Paul Hatchwell Tuesday 31 May 2022

The stated aim of many governments is to transition away from fossil fuels in line with the Paris Agreement – an aim made more urgent by the need to end dependence on Russian energy. The international Energy Charter Treaty risks frustrating these aims.

Advanced economies have been attempting to accelerate the decarbonisation of the energy sector in response to the climate crisis. Following Russia’s invasion of Ukraine in late February, Europe’s heavy dependence on Russian oil and gas pipelines has stung governments into action as they step up sanctions against Russia. Nowhere is this tension clearer than in Germany, which is undertaking an ambitious clean energy transition known as the Energiewende. However, in 2021 it was dependent on Russia for 55 per cent of its gas, a figure it is attempting to reduce (See: Germany’s accelerated energy transition)

But a deluge of investor-state arbitration claims under the Energy Charter Treaty (ECT) – signed in 1994 – risks frustrating these aims.

The ECT is a binding international agreement set up as an initiative of the then-European Economic Community. It ‘establishes a multilateral framework for cross-border cooperation in the energy industry […] The treaty covers all aspects of commercial energy activities including trade, transit, investments and energy efficiency’.

In the early 1990s, a key purpose was to give greater protection from political risk to foreign investors in a changing market dominated by fossil fuels, and the ECT has been highly effective in that regard. There are currently 52 contracting parties, among them the European Union and Japan. More countries are preparing to join, notably China and Nigeria.

Crucially, the ECT enables foreign investors to bring action against host governments through international arbitration tribunals where they have reason to believe their commercial interests could be adversely affected by energy policy and incentive changes implemented in breach of the international obligations of the host state under an investment agreement in force.

A proliferation of cases

Energy investment arbitration claims against host governments through the ECT for unfavourable policy changes have been proliferating for some time. These tribunals are, in many cases, preferred to the national courts of contracting states (in particular those within the EU), by foreign energy investors, mostly in the renewable energy sector but also in the fossil fuel sector. The tribunals provide higher rates of success and compensation payouts.

Glada Lahn, Senior Research Fellow, Energy, Environment & Resources at international affairs think tank Chatham House, stresses that ‘compensation from ISDS [investor-state dispute settlements] can be much higher than claims through domestic courts’, with awards calculated through income-based approaches. Cases can also drag on, such as the Yukos v Russian Federation case launched in 2005, in which annulment proceedings are still playing out.

Cees Verburg is an attorney-at-law at Dutch law firm Pels Rijcken & Droogleever Fortuijn and is focused on energy law, international arbitration law and ECT research. He notes investment tribunals ‘might be more willing to intrusively review governmental regulation than domestic courts typically are’. In practice, this hasn’t happened to date, with concern focused more on the indirect financial impacts of pressure on policymakers.

Investment tribunals might be more willing to intrusively review governmental regulation than domestic courts typically are

Cees Verburg
Attorney-at-Law, Pels Rijcken & Droogleever Fortuijn

So far, more than 142 cases have been processed or are in the pipeline. Most cases are brought by renewable investors, each for relatively low sums. Even so, a small number of exceptionally high claims from fossil fuel investors have accounted for a heavy financial burden on the energy transition.

Some consider that the impact of these claims can be overplayed. Alejandro Carballo Leyda is General Counsel to the Energy Charter Treaty, overseeing conflict resolution, ISDS issues and, crucially, modernisation of the treaty. ‘While several ECT cases are still pending, statistics point out that only around 40 per cent of the final awards found a breach of the ECT and awarded damages’, he says, adding that only in 11 cases did damages amount to 50 per cent or more of the initial amounts claimed. ‘In addition, important efforts are being carried out to promote the effective use of investment mediation.’

But Lukas Schaugg, an international law analyst at the International Institute for Sustainable Development (IISD), sees hypothetical valuation techniques, which often lead to very high awards, needing to change in future.

The burden of claims is far from evenly spread. The vast majority of claims – 60 per cent – are between EU-based investors and other EU host governments, with Spain in particular facing a long-standing deluge of investor claims. These mostly concern renewables and are often highly speculative (See: Spain’s charter woes). In the Netherlands, cases brought against the government’s phasing out of coal-fired generation are key concerns, while long-simmering tensions over the licensing of oil and gas pipelines to Germany from Russia, notably Nord Stream 2, are reaching crisis point following the invasion of Ukraine (See: Germany’s accelerated energy transition).

Many lawyers and policy analysts also argue that these claims can have a much wider effect on energy policy and the clean energy transition than the financial burden alone. Verburg notes that arbitrators do not call for changes to the policies being challenged, and instead focus on compensation. The overall effect is to make the clean energy transition more expensive rather than stopping it. ‘The ECT is one of the main tools to drive up the cost of phase-out’, says Schaugg, ‘to force governments to delay decisions, water down legislation – it is a lobbying tool’.

Global Insight has contacted the leadership of the IBA Energy, Environment, Natural Resources and Infrastructure Law Section in relation to this article, but had not received comment for inclusion at the time of publication.

The Energy Charter Treaty is one of the main tools to drive up the cost of phase-out, to force governments to delay decisions, water down legislation – it is a lobbying tool

Lukas Schaugg
International Law Analyst, International Institute for Sustainable Development

Hélionor de Anzizu, a staff attorney at the Center for International Environmental Law in Washington, DC and Geneva, points to evidence of a chilling effect on the clean energy transition, and says that, according to press reports, ‘some states have admitted that they pushed back their deadlines to phase out oil and gas exploration or exploitation, or watered down regulations due to investment treaties and the fear of arbitration claims’.

She adds there may be more examples, but that due to a lack of transparency and inconsistent methodology, ‘it is impossible to quantify precisely how many regulations have been affected by actual claims or the threat of new claims’. But de Anzizu considers the ‘chilling effect of ISDS is now well established’, and indeed, it was cited in the report of the UN Working Group on Business and Human Rights to the UN General Assembly in 2021, and by the Intergovernmental Panel on Climate Change in its latest report.

Annette Magnusson is a former Secretary General of the Arbitration Institute of the Stockholm Chamber of Commerce and co-founder of Climate Change Counsel, a Stockholm-based think tank. She says that ‘tribunals will not on their own initiative engage with the climate aspects of a dispute or consider the possible conflicts between investor protections and the host state’s climate obligations’, and that as with any other issue in international arbitral tribunals these need to be raised and argued by the parties in their submissions. She adds that ‘so far, we have not seen much evidence of this happening’.

Global Insight has contacted the senior officers of the IBA Arbitration Committee in relation to this article, but had not received comment for inclusion at the time of publication.

The modernisation of the Energy Charter Treaty includes as two important topics the revision of the definition of investment and investor

Alejandro Carballo Leyda
General Counsel, Energy Charter Treaty

The ECT has also been used to severely restrict progressive policy space. For example, action against Bulgaria and Hungary dissuaded them from implementing energy price cuts for consumers. Verburg is also unconvinced that the ECT promotes clean energy. ‘The econometric evidence that treaties such as the ECT lead to increased flows of FDI [foreign direct investment] and thereby may facilitate the energy transition is also inconsistent [at best]’, he says.

There’s a question to be asked, then, on why cross-border arbitration cases are so easy to launch. Ignacio Arróniz Velasco, a researcher on trade and climate in the Clean Economy Programme at think tank E3G, says that ‘a major flaw of the ECT enters the scene here: its limits on shell companies are very antiquated, so major Russian companies can easily do “treaty shopping”, launching arbitration cases against EU governments through their national subsidiaries’. The most notable risk here is the controversial Russian gas pipeline Nord Stream 2.

However, Leyda, the ECT general counsel, says that ‘The modernisation of the ECT includes as two important topics the revision of the definition of investment and investor to address some of those concerns’.

A clash of norms

There has long been disagreement over whether arbitrators have the right through international law, via the ECT, to bypass national law in EU Member States or whether the national laws of the European Community, as a regional economic integration organisation (REIO), have primacy or are merely a subsystem of international law. This goes back to legal philosopher Hans Kelsen’s much older question of whether national constitutions or the international order are the ‘grundnorm’ – the underlying basis for the legal system that takes precedence.

A University of Amsterdam legal analysis for environmental law charity ClientEarth published in April 2022 highlighted a fundamental issue: that the ECT allows interference in the autonomy of EU law ‘by enabling investment tribunals to interpret and apply EU law without introducing the necessary safeguards that preserve the EU’s unique legal and judicial framework’. An example of where such safeguards can be found in modern treaties is the EU–Canada Comprehensive Trade Agreement. Another key flaw, the analysis found, is that the ‘ECT adversely affects the operation of the EU institutions in accordance with the EU’s constitutional framework’.

Fixing the treaty

An influential but controversial legal ruling by the Court of Justice of the European Union (CJEU), Republic of Moldova v Komstroy LLC, in September 2021, found that the investor–state arbitration clause contained in Article 26 of the ECT could not be used between EU Member States. The Court did not put a time limit on its judgment, so there are implications for future, pending and already concluded arbitration.

The judgment followed a similar ruling by the CJEU in Achmea BV v Slovakia in 2018, which found that intra-EU bilateral investment treaties (BITs) – of which there are more than 190 – are incompatible with EU law. This was despite a 2017 advisory opinion by the EU Advocate General that BITs were compatible.

But while these judgments raise risks for investors, they’re not a fully effective defence against arbitration cases for governments, with the restructuring of cross-border companies typically giving options for arbitration to be switched to ECT jurisdictions outside the EU that have BITs with the target states.

ClientEarth’s 2022 analysis confirmed that, as it stands, many aspects of the ECT are fundamentally incompatible with the EU Treaties. In line with a growing consensus of legal opinion, it recommended that EU institutions and Member States must withdraw or else ensure the ECT’s urgent amendment.

Broadly, there are three widely discussed solutions that could minimise, or at least avoid, a costly and disruptive future flood of arbitration claims. Firstly, the EU could work with all other ECT members to amend the Treaty, a process called ‘modernisation’. Secondly, an inter se agreement might be struck between EU Member States and other ECT parties open to reform. Finally, the ECT agreement could be terminated if all parties agree.

The European Council is currently acting on a mandate to negotiate modernisation of the ECT to bring it into alignment with the EU’s recently revised approach to investment law. To this end, proposals have been made in 13 negotiation sessions since 2020.

Germany's accelerated energy transition

Since Russia’s invasion of Ukraine, the German government has dramatically reduced its dependence on Russian oil, from 35 per cent to 12 per cent. Although Germany has been under intense pressure within the EU to come off Russian gas, it expects to still be largely reliant on Moscow until mid-2024. It was dependent on Russia for 55 per cent of its gas in 2021 and has been attempting to reduce this since the invasion of Ukraine.

While the Kremlin and major Russian gas supplier Gazprom have dismissed the possibility so far, it also appears that a sudden punitive gas cut-off by Russia in retaliation for Germany’s sanctions is far from theoretical – as Bulgaria, Finland and Poland have found after they refused to pay for Russian energy in roubles.

The German Ministry for Economic Affairs is preparing a plan to cope with abrupt cut-offs, including the potential nationalisation of infrastructure, the state taking shares in critical companies and the rationing of gas supplies.

Though there’s little comment from Moscow in this respect, there’s the potential for action under the ECT. Russia has long since withdrawn provisional application of the ECT, but Russian corporations Rosneft and Gazprom can still take cross-border action through European subsidiaries, as could contractors.

ECT contracting parties have committed to an agreement in principle on modernisation of the Treaty before the end of June 2022. But Schaugg at the IISD points to widespread criticisms that the reform process is ‘entirely opaque’. He says ‘there has been an attempt to reform for three years now and this has been almost entirely unsuccessful’, and concludes that EU Member States must urgently address their ISDS issues.

ClientEarth’s 2022 analysis confirmed that, as it stands, many aspects of the ECT are fundamentally incompatible with the EU Treaties. In line with a growing consensus of legal opinion, it recommended that EU institutions and Member States must withdraw or else ensure the ECT’s urgent amendment.

Broadly, there are three widely discussed solutions that could minimise, or at least avoid, a costly and disruptive future flood of arbitration claims. Firstly, the EU could work with all other ECT members to amend the Treaty, a process called ‘modernisation’. Secondly, an inter se agreement might be struck between EU Member States and other ECT parties open to reform. Finally, the ECT agreement could be terminated if all parties agree.

The European Council is currently acting on a mandate to negotiate modernisation of the ECT to bring it into alignment with the EU’s recently revised approach to investment law. To this end, proposals have been made in 13 negotiation sessions since 2020.

ECT contracting parties have committed to an agreement in principle on modernisation of the Treaty before the end of June 2022. But Schaugg at the IISD points to widespread criticisms that the reform process is ‘entirely opaque’. He says ‘there has been an attempt to reform for three years now and this has been almost entirely unsuccessful’, and concludes that EU Member States must urgently address their ISDS issues.

Proposals for reform of the ECT face a long and tortuous process, particularly given that amendments to Article 26 are not even an agreed part of the agenda for the discussions of the Energy Charter Conference on modernisation.

Speaking in a personal capacity at a webinar in April hosted by the Centre for International Environmental Law, ClientEarth, and the IISD, Nicolaj Kuplewatzky, Référendaire at the CJEU, pointed out that the CJEU ‘did not find that substantive provisions of the Energy Charter Treaty are incompatible with EU law, it’s solely the dispute settlement provision. So, the substantive provisions can continue to be relied on, especially before a European court’.

To limit the harm from the ECT, Kuplewatzky proposes an update to the declaration on intra-EU inapplicability between the EU Member States as adherents to the EU Treaty, ‘to finally have one single declaration collectively expressing the understanding of the member states, the masters of the treaties, they are still sovereigns, so that that they can be used as a means of interpretation in pending arbitrations’.

Beyond this, he suggests an agreement between EU Member States that Article 26 of the ECT has been inapplicable all along, which would remove uncertainty in respect of the international position, and that this agreement is created in parallel with ‘a separate treaty that ab initio cuts those ties so that that mandate disappears’.

Kuplewatzky also suggests that ‘what should be done here is to apply for anti-arbitration injunctions in national and foreign courts, so very much like what [the] Netherlands has done in the Uniper case against Germany’. He supports suggestions by Commission lawyers ‘that there should be tort claims against investors that commence such intra-EU actions after these Achmea and Komstroy […] judgments’, noting that ‘Article 19 [of the EU Treaty framework] sets up a clear institutional and judicial system [...] if you seek to circumvent that system you violate EU public policy’.

Reaching an agreement

Leyda takes a more upbeat position. He says that arbitral tribunals under the ECT ‘have confirmed that the host state is entitled to maintain a reasonable degree of regulatory flexibility to respond to changing circumstances in the public interest’. But the tribunals have also qualified this, adding that ‘subsequent regulatory changes should be made fairly, non-retroactively, consistently and predictably, taking into account the circumstances of the investment’.

Dr Leyda also stresses that the right to regulatory reform, provisions on sustainable development, the climate crisis, the clean energy transition, the Paris Agreement – together with the gradual exclusion of investment protection for fossil fuels that reflects the flexibility principle enshrined in that agreement – and clarification of ECT application to REIOs such as the EU, are all topics on the table in the modernisation negotiations. These aim to reach an agreement in principle on 24 June 2022. He adds that mention of the Paris Agreement would be the first such clear reference in any investment agreement.

Schaugg notes that the parties, especially the EU, are ‘trying to reach an agreement to modernise the Treaty this year’. However, many issues are unresolved and there are widely varying interests among the contracting parties and signatories, who include large fossil fuel producers. Achieving satisfactory reforms in line with the Paris Agreement, which provides flexibility and different paces for transition, and the EU Green Deal for climate neutrality by 2050, requires unanimity, which will be challenging to obtain. ‘All this while the clock is ticking for climate policy’, says Schaugg.

Spain's charter woes

Spain has suffered 50 arbitration claims under ECT, more than any other country. It has been ordered to pay €971m across 18 cases. Arroniz Velasco at think tank E3G says that, of the ECT cases concerning renewable energy, 60 per cent were related to a single policy change: Spain’s amendment of its feed-in tariff for wind and solar.

The Spanish state has ‘endured almost a decade of complicated arbitration, facing multi-billion claims, but did not reverse its policy because of this’, adds Arroniz Velasco, who says that ‘only a change of government brought a new impetus to the energy transition, not the risk of litigation’.

Arroniz Velasco also says that some 89 per cent of these cases were brought by equity funds or other financial investors rather than those who insisted on changing the policy. ‘If you want to manage political risk to attract renewables, many more bespoke arrangements are available that do not entail blanket limitations to [a] government’s ability to design energy or climate policy.’

Officially, the EU remains committed to its modernisation mandate to negotiators. But as the deadline for completion of reforms approaches, the EU and several of its frustrated Member States are understood to be privately considering alternatives, including following Italy into withdrawal, if reforms fail.

Such a move is not without ongoing risks from claims, as Italy has found since its exit in 2016. Verburg says that ‘withdrawal without amendment is not really a good solution due to the presence of a 20-year sunset clause’. There are risks too because the ECT lacks a termination clause.

The consensus among most experts, if adequate reforms fail to pass, is that the EU and all other parties could cancel the Treaty simultaneously. This would effectively rule out new claims, but the unanimity needed looks very unlikely to be obtained.

Another pragmatic solution on the table, and one that’s favoured by many non-governmental organisations and several EU Member States, is for all EU parties and progressively-minded states to withdraw from the ECT and establish a more favourable inter se agreement simultaneously. This is allowed under Article 41 of the Vienna Convention on the Law of Treaties, though the fact that contracting parties to the ECT are not all parties to the Vienna Convention could complicate this strategy. ClientEarth’s Amsterdam opinion also proposes ‘an attached interpretative declaration that avoids circumvention of the inter se modification through relocation to a not withdrawing, non-EU Contracting Party to the ECT’.

Given that intra-EU ISDS claims dominate two-thirds of the ECT cases to date, Schaugg says that most new claims could be blocked if the sunset clause ‘could be neutralised among the withdrawing states’.

One thing most agree on is that threats to climate policy and energy security from investment arbitration are likely to intensify, as ambition – accelerated by the Ukraine crisis, the accession by poorer or institutionally weak developing countries and by treaty shopping – increases, unless the ECT can be reformed or neutralised quickly.

Paul Hatchwell is a writer, researcher and consultant on policy and practice in energy and climate, sustainability and green finance issues. He can be contacted at paul@hatchwell.net